How well prepared were Latin American countries for the global crisis? This column uses two decades of data from the region to argue that, just as inflation-targeting rules institutionalised robust monetary policy and helped to curb rises in the price level, countercyclical fiscal policy must be institutionalised to be effective and sustainable. Chile, it says, is leading the way.

Latin America overcame the 2008-2009 international crisis in remarkably robust macroeconomic health. At the onset of the crisis, most countries in the region had positive budget surpluses, reasonably low debt-to-GDP levels, and credible monetary policies – thanks, in several cases, to inflation-targeting regimes. As the crisis progressed, policymakers could boast of significant fiscal packages while keeping country risk in check. These solid balances stood in stark contrast to the region’s historic performance, in which fiscal fragility had been at the root of protracted crises, including the dramatic debt crisis of the 1980s (see OECD 2009 for a comparison). While the first two quarters of 2009 witnessed all countries suffering significant slowdowns – in many cases, recessions – by mid-2009, most economies were showing solid signs of recovery.

Was this success due to greater policy space that allowed the use of effective countercyclical fiscal policy? It is too early to answer this question with precision given the limited information on the actual implemented packages, the uncertainty on the size of fiscal multipliers (which vary for cyclical and structural factors – e.g. Ilzetzki et al. 2009 on this site), and the combined effects of other favourable external factors involved. Yet still, using OECD methodology, some steps can be taken to contribute to this ever-growing debate by measuring automatic and discretional fiscal stimuli in several Latin American countries between the early 1990’s and 2009.

Estimating structural fiscal balances using OECD methodology

Even before the Lehman collapse in September 2008, a debate had started among analysts on the cyclical or structural nature of significant, but still recent, fiscal improvements in several Latin American economies. For example, Izquierdo and Talvi (2008) of the Inter-American Development Bank apply the Chilean methodology to estimate structural fiscal balance (see Marcel et al. 2001) and argue that only Chile was performing significantly more countercyclically than during the 1998 Russian crisis. By contrast, using a different methodological approach, IMF economists Vladkova-Hollar and Zettelmeyer (2008) observed an improvement in structural balances in most countries (although commodity prices added a significant layer of uncertainty).

In an OECD Development Centre Working Paper (Daude et al. 2010), we track structural fiscal balances for Argentina, Chile, Colombia, Costa Rica, Mexico, Peru, and Uruguay. We use a standardised OECD methodology (see Van den Noord 2000, Girouard and André 2005, and De Mello and Moccero 2006) which we augment to include the fiscal impact of commodity prices. The latter is an important factor in several Latin American fiscal balances, which we include following Vladkova-Hollar and Zettelmeyer’s approach.

Our results provide a measure of the automatic stabilisers embedded in four categories of taxes (personal income tax, corporate income tax, social contributions, and consumption taxes). Together with the adjustment for commodity prices, these results compute the degree of cyclicality of discretionary fiscal policy and allow a comparison with debt sustainability indices (the latter in terms of how far off current fiscal balances are from a long-run sustainable benchmark). These exercises can be then compared to fiscal-stance estimates from OECD countries.

Countercyclical and sustainable at last? Not really…

We obtain five fundamental results:

In several countries, commodity cycles affect fiscal balances as much as economic cycles. Commodity prices contributed significantly to improve fiscal positions in latest years (around 1 percentage point of GDP in Argentina, 2 in Mexico, 3 in Peru and over 6 percentage points in Chile).\

As shown in Figure 1, tax automatic stabilisers are significant, although fairly small. Primary budget balances have an automatic response of 0.21 percentage points of GDP for each percentage point of output gap in the region. However, there are significant differences within Latin American countries, ranging from 0.12 percentage points of GDP in Mexico and 0.14 in Colombia, to around 0.25 percentage points in Argentina, Brazil, Costa Rica, and Uruguay. These numbers are on average almost half the average responsiveness in OECD countries, a gap mainly explained by a significantly lower automatic-stabilisation of personal income taxes due, in turn, to a low income-tax base.

3. Since the early 90s, discretionary fiscal policy (defined as changes in fiscal balances unexplained by automatic stabilisers and commodity adjustments) has been procyclical in Argentina, Brazil, Costa Rica, Mexico, and Uruguay; while neutral in Chile, Colombia, and Peru. We find no clear progress in the degree of discretionary countercylicality in the last decade. For this period, procyclicality is mainly driven by the deep crises, as illustrated by the Argentinean and Uruguayan episodes in Figure 2. From 2000, fiscal policy has been more procyclical or, at best, just as procyclical. With these criteria, good practices emerged once again from Costa Rica, where discretionary fiscal policy has turned countercyclical, and Chile (where it was maintained throughout the period analysed).

4. From a structural perspective, both cyclically-adjusted balances and debt sustainability analysis confirm that most countries in the region had improved their position by the time the crisis erupted. Of course, in 2009, all countries present a considerably lower structural balance than in previous years, given the automatic and discretionary fiscal expansion in response to the economic crisis. However, all countries (except Argentina) have been able during the last decade to achieve fiscal balances above those required to sustain their current debt levels, such that they could be expected to reverse expansionary policies without major difficulties.

5. There is a great degree of uncertainty concerning output gap estimates in Latin America. Compounded with highly volatile cyclical shocks, there is evidence of highly volatile trends for potential output, which add an extra layer of complexity for policymakers in the region.

… but with several good practices after all

According to our estimates, at the onset of the crisis in 2008, adjusted primary balances were in equilibrium or surplus in a majority of countries (1 percentage point of GDP in Peru, 2 in Uruguay, 2.5 in Brazil, almost 3 in Chile and Colombia, and 5 in Costa Rica; -1.0 percentage points in Argentina and -3.6 in Mexico). So, even taking into account the positive economic and commodity price cycles, these figures confirm that the region faced the crisis in relatively good fiscal shape.

Moreover, based on the correlations of the variation of the adjusted budget balance and output gap level, Chile shows to some extent a countercyclical pattern, while in Colombia and Peru discretionary fiscal policy has been fairly neutral.

The way forward

Just as inflation-targeting rules institutionalised good monetary policy and helped curb rises in the price level, countercyclical fiscal policy must be institutionalised to be effective and sustainable. Even in those countries that exhibited effective countercyclical fiscal adjustments, thanks to proper fiscal rules and/or credible institutions, there is space for improvement. In particular, as a recent IMF survey points out, only about half of countries operating under fiscal rules did not modify or temporarily suspend them during the recent crisis. A proper design of exit clauses, to minimise the vulnerability of fiscal rules to unpredictable exogenous shocks, is needed (Ter-Minassian 2010).

Chile, the Latin American country that has advanced the most by establishing explicit structural fiscal rules, may be leading the region, with its recently constituted commission of experts to offer improvements on the current criteria. Guiding principles for such improvements, as articulated by this commission, are stability, predictability, transparency, and accountability. The time is ripe for such advances, since the general public is arguably more aware of their benefits, having seen the payoff of prudent fiscal behaviour in good times in order to have resources needed to deal with times of hardship.